I had this article published today in the compliance industry resource site Complinet

I'm using the material as source for a series of articles aimed at newspapers.

The Future of Compliance: Part One - Peak Credit

Mar 28 2008

Surveying the aftermath of JPMorgan's dramatic acquisition of Bear Stearns and the impotence of the Federal Reserve's "conventional" monetary solutions, it is clear that dramatic, and unprecedented, events are unfolding. Since this is a dynamic process, any commentary is subject to be contradicted within 24 hours, resurrected as conventional wisdom in a week, and dispatched to the outer darkness of history within a month. Whatever the outcome, however, some of the regulatory issues have been evident for some time and others are now emerging.

This article is the first of two concerned with the effect of current developments upon the world of compliance. Despite the kind of special pleading currently seen from the likes of Alan Greenspan, the former chairman of the US Federal Reserve, the effects of this regulatory disaster can only be a call for a retreat from the process of deregulation many commentators regard as responsible.

To predict where the compliance industry goes from here it is necessary to outline the events and trends which constitute almost tectonic movements in the financial markets. To do so, compliance is approached as an essential form of market "quality control".

Peak credit?

The subject of "peak oil" is usually misrepresented to mean "oil is running out" but in fact means that, "while there may be plenty of oil in the ground, there is a maximum (peak) level of production which we may even have reached". Peak oil has gradually evolved from a wild "crank" theory to the relative respectability of -- a well-known phrase -- an "inconvenient truth".

The consequences of peak oil are not within the scope of this article but serve as an analogy for another phenomenon -- peak credit, which, like peak oil, may in fact already have occurred.

Banking

A bank is a credit institution with a monopoly privilege to create credit backed by an amount of regulatory capital set by the Bank for International Settlements (Basel Accords I and II). The interest-bearing loans or credit which banks create is actually the money we use, and this keeps the economic world turning on its axis. Credit institutions create this money which is then instantaneously re-deposited back into the banking system. Without this flow of new credit there would be no development and no economic growth.

It should be noted at this point that most people -- even the most financially sophisticated -- are under the misapprehension that what banks do is to first take in deposits (i.e., pre-existing money) and then, second, loan them out again. This is actually what credit unions do and what "licensed deposit takers" (prior to the Financial Services Act) used to do. The fact is, however, that credit institutions (aka banks) actually create loans first as new money which become deposits second. There is intense competition among banks to gather in these deposits at an advantageous rate of interest.

Credit intermediation

There are two types of credit:

* "Trade" credit -- extended by a seller to a buyer and familiar to anyone involved in bilateral over-the-counter markets.

* "Bank" credit -- extended by a bank to a borrower and by a depositor to a bank.

The economic role of a bank is to stand between or "intermediate":

* Borrower -- someone who is receiving something of value from the bank and promising to provide something of value in the future; and

* Lender -- someone who is giving something of value in exchange for a promise from the bank to provide something of value in the future.

If we deconstruct this relationship we see that the bank is guaranteeing the credit of the borrower. The charge the bank makes for doing so (interest) must cover interest paid to depositors, the bank's operating costs and the costs of defaults, and will hopefully thereby provide an additional margin as profit.

In other words, the credit itself does not cost anything to create. It is the guarantee function that is the economic value provided by the bank and this implicit guarantee is supported by the pool of "regulatory capital".

Asset-based and deficit-based finance

As credit involves a "promise to pay" and as "debt" constitutes one of the "twin peaks" of financial capital, credit may be thought of as "deficit-based" finance. The other peak is "equity", which involves actual "ownership" of productive assets in legal vehicles.

Historically, this has been the "joint stock limited liability company" or "corporation"; however, there are an increasing number of alternative vehicles such as trust and partnership-based vehicles, which together may be thought of as "asset-based" finance. The problem is that the bulk of financing of productive assets globally has been a hybrid,

i.e., for the most part, it consists of credit that credit institutions have created and secured by a legal claim over productive assets that the borrower owns.

Deficit-based finance that is "property-backed", i.e., mortgage loans, underpins in excess of two thirds of the money which the Federal Reserve Bank and the Bank of England issues.

Asset bubbles

The first credit-fuelled "bubble" was the one that the remarkable Scot, John Law, instigated in France, when he created the first example of a central bank in recognisably modern form in 1718 -- the Banque Royale -- and used it to fuel a massive speculative bubble in the share price of the French Mississippi Company (Compagnie des Indes).

Since then, a never-ending series of financial bubbles has been a recurring phenomenon in the financial markets and all bubbles have involved the excessive use of deficit-based finance by investors to buy productive assets.

The result is that asset prices lose touch with the reality of the underlying revenue flows that the assets have generated. Inevitably, the asset price reaches a level at which no further borrowing is possible and the asset price collapses, taking the borrower, and often, the banks which deficit financed the bubble with it.

The pyramid of cheap dollar-denominated credit built in recent years upon US land rental values is such that the current process of "de-leveraging", which has only just begun, is, at worst, in danger of sucking the US into a depression or, at best, a Japanese-style economic stasis.

Some would argue that the credit level created in the US reached an unsustainable peak some months ago and that a fundamental restructuring -- a Bretton Woods II -- is now necessary.

The role of banking innovation

The main issues have been the emergence of new financial techniques, and the re-emergence of old ones, and the regulatory response to these. In recent years banks have been increasingly able to "outsource" to investors the risks of their implicit guarantee. This risk transfer has occurred in three principal ways:

* Securitisation -- permanent transfer.

* Credit derivatives -- temporary transfer for a defined period.

* Credit insurance -- partial transfer.

There has also been a massive growth of complex structured products that involve the "dicing and slicing" of risk.

The regulatory risks inherent in securitisation are not new. These were the principal reasons for the separation by the Glass-Steagall Acts in 1933 of investment banking and commercial banking in the aftermath of the US stock market bubble which led to the 1929 Wall Street Crash.

There have already been calls for the reinstatement of this separation and these calls are likely to grow stronger both as the current crisis unfolds and as lessons are digested in the aftermath, whenever that begins.

Clearly, there will be a reappraisal of the other risk transfer mechanisms as well. In particular, the capitalisation of "monolines" and the risks they undertake in ensuring credit risk will be the subject of intense regulatory scrutiny.

Credit derivatives have proved too useful a tool to be destined for oblivion, unlike most of the financial "toxic waste" now gravitating towards the Fed silo. There may be an increased emphasis on transparency, however, and a drive towards standardisation of terms.

Rating agencies

The role of rating agencies and, in particular, the commercial conflicts of interest between the shareholder owners of such agencies and some of the market participants who rely on their neutrality, has already come in for considerable debate and discussion.

This debate is expected to continue and the relationship between regulators and agencies will be reviewed. One radical approach might be to encourage the evolution of a new generation of rating agencies that operate on a not-for-profit basis.

Asset-based finance and 'unitisation'

New asset-based financial tools are continually evolving. For example, the emergence of "income trusts" and "royalty trusts" in Canada has created an entirely new asset class of "units", which comprise rights to part of the gross revenues of listed corporations that have been attractive to long-term investors, such as pension funds who see an advantage in accessing corporate revenues before the management does.

The recent Blackstone IPO was not dissimilar, in that it was not a sale of conventional shares but a sale of partnership interests in Blackstone revenues.

Other growing forms of asset-based finance are: exchange-traded funds; real estate investment funds; and Islamic finance, which is inherently asset-based albeit some of the current generation of "sukuk" vehicles do not necessarily share risk and reward in a way that most Muslims would consider ethical.

Asset-based finance may also be used as a replacement for the increasingly scarce availability of deficit-based, but asset-backed finance. This will continue to be the case at least until banks' balance sheets have been repaired, which -- as we have seen in Japan -- may be a very lengthy process, and moreover, a process that cannot even begin until the market has stabilised.

Governments and guarantees

The contrasting approaches of the US regulatory system, which the Fed drives, and the fragmented "tripartite" (HM Treasury, Bank of England and the Financial Services Authority) approach in the UK have been brought home by the marked difference in the protracted Northern Rock saga and the blitzkrieg approach of the Fed to Bear Stearns.

Decisiveness is all very well of course but the political ramifications, in particular, the democratic accountability and transparency of both the Northern Rock and Bear Stearns "rescues", require careful study.

It is possible to imagine a new approach to the roles and responsibilities of national financial regulators, treasuries, monetary authorities and central banks. Indeed, it is even possible to question the necessity of a central bank at all -- Hong Kong, for instance, has never had one.

The challenge of napsterisation

The next article will consider the continuing and profound changes which flow from the pervasive spread of the internet and, in particular, the effect that the arrival of peer-to-peer direct connectivity ("napsterisation") is already having on the legal and financial structure of markets.

Markets are becoming globally networked; however, regulation remains firmly bound to disparate national jurisdictions. Regulation that is appropriate for intermediaries is entirely redundant for the regulation of "end user" market participants on the one hand and the emerging breed of market service providers on the other.

It is here, in the current transition from "transaction-based" markets that involve intermediaries in a new generation of globally networked markets based upon new forms of service provision, that new opportunities and challenges lie and the compliance industry will be at the heart of this transformation.

My subversive plan is to start a distressed mortgage-backed-security valuation outfit ("the outfit"), value the securities as if default were a writeoff (repossession with no prospective buyers), therefore valuing them cheaply, and if and when default does happen, instead of repossessing offer people to restructure their debt through a community land partnership in which "the outfit" is just an equity investor and the market rent (lower than the mortgage payment that caused the default but a roughly inflation-indexed cash flow nonetheless) goes towards paying "the outfit" a "capital rental". The "capital rental" is payable as a combination of cash and "equity shares" (useful in really dire times for the owner-occupier) and excess payments go towards repurchasing the capital contributed by "the outfit".

It'd be nice if the battle were only against the right wingers, not half of the left on top of that — François in Paris

Just kidding. 'Equitize' may be exactly the term that we need. We should write everything on this, and related, subjects and include this term - or "fairsharing". Not kidding.

Migeru - I hope that we will have substantial time to talk in Paris - May 3, yes? (I will follow up the meet-up diary with a plan diary this weekend.) I am hopeful that we are going to start to set up some kind of deal that will include a career of this type for you. So - I trust that you're not teasing - excessively - in your comment above.

Well, as long as it's not Euros, we should be OK. At $10,000 each, that's only 100,000 members (or shares at any rate). Best start planning. By the way - you will help with marketing, too? At least, at the first?

This plan is a key part of what solveig and I have been working to achieve since we met, and indeed, was actually why we met.

We formed NET Partnership LLP for the purpose and it currently consists of:

(a) Nordic Enterprise Trust ("NET") - Scottish charity, and a Company Limited by Guarantee - which is the "Custodian" of both the relevant "Intellectual Property", and "Purpose" of the LLP (signatory solveig);

(b) solveig herself, as the other initial "founder" member and (currently) sole "Operating member".

I worked with NET to develop both the above LLP and the "Capital Partnership" and "Guarantee Society" concepts.

We received a little backing from Innovation Norway (ie the Norwegian government), but for the most part have funded this ourselves.

We are involved in one major (300 property) demonstration affordable property scheme in Scotland.

But building new developments is only part of the model: there is equal potential in refinancing existing assets.

I have for many years seen the refinancing of debt with a new form of "non-toxic" Equity as being a key component of a new and fairer financial system and have written about it extensively on this site, explaining it under forensic questioning, particularly from Migeru!

NET is already in the process of discussing a joint venture with financiers (a major property fund) and "ethical developers" in respect of just this.

Both solveig and I believe that detailed development work should be carried out outside the glare of the ET spotlight.

We are of course happy to work with the right people to develop these concepts provided of course that we agree:

(a) a common purpose;

(b) who does what, and for what.

I believe that many of the "right" people are to be found at ET.

"The future is already here -- it's just not very evenly distributed"
William Gibson

from what i understand, your system spreads the risk, in much the same way as napster shared server loads, is that the correlation?

Indeed. The current position is that the risk load - which originates from the "end user" market participants - is currently being borne by middlemen/intermediaries.

Moreover, these risk intermediaries - and credit institutions are only one class, we also see "Central Counterparty" Clearing Houses - have been consolidating over time and now constitute what I believe to be "single points of failure".

The system must be disintermediated, and the risk shared between the end users who originate it. That process of risk outsourcing is what happend imperfectly and opaquely and led to the current disaster. We need a new, and simple, approach.

That is what "Peer to Peer" connectivity enables, and is what I was writing about seven years ago here

Actually, the current credit crisis is not the result of risk concentration, but of the wide dispersion of risk via securitisation in such a way that nobody know who's left holding the bag and so nobody trusts anyone else and the credit system gets all gummed up.

In other words, it would be a good thing if risk were concentrated in a few, identifiable, "single points of failure" because then the failures could be contained.

Instead we have poorly diversified risk in a majority of institutions (which makes them rather vulnerable to shocks) and, in addition, the spreading out of this risk through securitisation (which allows those doing the securitisation to generate even more risk).

In that sense, it's not clear to me how peer-to-peer "risk sharing" is a good thing. If risk is not confined to small containers it gets much harder to control.

It'd be nice if the battle were only against the right wingers, not half of the left on top of that — François in Paris

In other words, it would be a good thing if risk were concentrated in a few, identifiable, "single points of failure" because then the failures could be contained.

That's the theory. But the risks would not be "contained".

What you get is the likes of Shell, BP, and Gazprom plus hedge funds - not to mention the investment banks' proprietary teams who ride on the backs of the others - all outside the box.

And if you look at the capitalisation of the typical clearing house it's not even a pimple on the arse of the risks they run.

A clearing house is an almost precise analogy of a credit institution. They keep a cushion of capital (equity plus margin) to cover defaults.

The trouble is that I would bet my bottom dollar that their risk management is inadequate in addressing the "black swans" eg a London Tin Crisis, or a Metallgesellschaft (where NYMEX was dead lucky that the Germans bailed them out) and IMHO the bigger they get, the bigger the disaster when it comes: which, like an earthquake in an earthquake zone, it inevitably will.

Simply unitising risks into "n'ths" allows it to be pooled among and backed by all of the end users, with default pools held by a "Custodian".

The risk continues to be managed by the same people as service providers who are currently doing so as intermediaries.

"The future is already here -- it's just not very evenly distributed"
William Gibson

An excellent overview of the financial aspects of the current crises. What I would really love to see you explicate is how the financial system can be "tied" or "bound" (gagged, too?) to the real economy. My view of the situation is that the financial markets are in crises exactly because they have grown so much bigger than the real economy has - the point made two weeks ago by Eric Zencey in The roots of the subprime crisishttp://www.eurotrib.com/story/2008/3/11/122016/316

The point is, to use an old adage, you can't eat bonds or other paper (well, you could, but the nutritional value is questionable, and it would certainly be far too much roughage). It is the real economy that provides what we need to live - the food, clothing, shelter, transportation, medical services, education, and so. How then do we ensure that the financial system is first and foremost serving the needs and interests of the real economy?

The situation we find ourselves in today is that the real economy has been neglected and so distorted that so many of the costs of externalities have been borne by the ecological environment that many experts and laymen believe we are threatening our very physical existence. At the very least, it makes no sense to continue to burn fossil fuels as the basis for most activity in the real economy: whether they last ten years, a hundred years, or a thousand years really does not matter, there simply are finite supplies of the stuff. Personally, more worrisome to me are the very apparent strains on fresh water supplies.

Now, fixing these problems will require enormous amounts of money. Where shall such amounts be obtained? Under our present financial arrangements, they cannot. Yet, the equivalent of three to five trillion dollars or more are traded each and every day in various financial markets around the world. I would venture to guess that some 99 percent of those financial flows do nothing at all to help the real economy; certainly they do nothing to help solve the problems we face in resource depletion and misuse. Thus, the major problem I see that needs to be solved is how to compel those flows of money (or credit, or whatever the technically term is), into helping solve the real economic problems that we face. As I have written before: how do we ensure that the credit mechanism of the economy is not being misused for private gain? How do we ensure that the credit mechanism of the economy is instead being misused for to advance the public good?

Here is where the fight lies. Neo-liberal economic theology, laissez faire posits that the greatest public good results when the markets are given the widest possible freedom. I believe the current crises - taken on its own merits as merely financial crises and leaving aside the whole issue of how the financial systems helps or hurts the real economy - shows that Neo-liberal economic theology is grievously mistaken in its approach to achieving the greatest public good. What comes now is the political struggle as certain vested interests argue vociferously for - what it boils down to - their "right" to make a profit at the expense of the public good. These vested interests of course can never admit that the public good - in terms of the ecological environment and / or the physical capacity of the real economy to support and sustain a dignified level of human life for everyone - is now so endangered that any supposed "right" to make a profit at the expense of the public good can no longer be tolerated.

But to return to my key question: How do we ensure that the credit mechanism of the economy is not being misused for private gain? How do we ensure that the credit mechanism of the economy is instead being misused for to advance the public good? And the credit mechanism, of course, is the financial system.

Now, fixing these problems will require enormous amounts of money. Where shall such amounts be obtained?

The solution lies in a "Debt/Equity" swap on a massive scale. All of the existing mortgage debt and securities in their myriad manifestations will be gradually exchanged for units of index-linked property rental revenue flows.

Affordable rentals for the occupiers on the one hand (because no capital is repaid, and an index-linked return is lower than a conventional return).

A reasonable - say 1 to 2% real return - on the other hand with the attraction that the affordability of the rental leads to greater certainty of payment.

The outcome will be that the greater part of value in circulation is then "land-locked" in that it is redeemable only in the country of issue. ie exchange control is built in....

Cross border value flows, on the other hand, would be of fungible units of energy, and of course in the labour value we ourselves produce.

All of these fungible units will be exchanged on what is a barter network or "International Clearing Union".

Any necessary credit = "time to pay" will come from the use of risk sharing "Guarantee Societies" which are backed by provisions made into "Pools" of value units by both buyer and seller.

This is exactly what Keynes had in mind with the "Bancor" when he suggested that both holders of positive and negative Bancor balances should pay a charge in respect of their balances.

But to return to my key question: How do we ensure that the credit mechanism of the economy is not being misused for private gain? How do we ensure that the credit mechanism of the economy is instead being misused for to advance the public good? And the credit mechanism, of course, is the financial system.

The result of the "unitisation" of secured credit within partnership-based frameworks would in fact give rise to a system with no "rentiers", where all finance originates from the productive economy.

A world without "Debt" in fact.

"The future is already here -- it's just not very evenly distributed"
William Gibson